Post Re-Org Equity: Spansion (CODE)

Every few months, I post an idea from the Distressed Debt Investors Club to give potential guests and members a feel for the ideas on the site. Remember, we have unlimited spots for guests that have a 50 day delay access to the database. We only have about 50 member spots left which give you access to the entire database and the forum (which I post on 2significantly more than this medium).

Last week, a member wrote up Spansion (CODE), a post-reorg equity with a target of $30/share with potential upside from there on additional royalty sales. Enjoy!

Company Name / Ticker: Spansion / CODE

Synopsis

The core thesis is that you have a hugely cash generative business, that is characterized by stable predictable orders, benefitting from a global trend towards increased electrical automation and increased content in all manner of industrial applications. EBITDA growth is continuing to grow steadily yoy each quarter in the core business, and now with the licensing revenues, CODE should have nearly double digit rev growth for the next two years and over 20% growth in EBITDA this calendar year. Incrementally you are long optionality based on litigation strategies and licensing opportunities on the IP portfolio. At $30, Spansion would be at 5.2x ’11 EBITDA and trading at an 11.6% ’11 FCF yield and we have yet to add value from royalties from Elpida sales or other incremental value from future licensing opportunities.

Write-Up

Business Description:

Spansion is a leading nonvolatile flash manufacturer. The primary focus of the company is NOR flash, which has superior reliability and fast read times, which makes it used widely for code storage, boot up instructions, and execute in place (XIP) applications in all manners of electronics. The company has ~36% mkt share in the embedded market. Spansion's segments are approx. 41% consumer and gaming, 22% auto and industrial, 12% computer and comms, 19% wireless and M2M, 5% other. The company will benefit by continued electronic content and active safety control features in autos, smart meters, increased industrial automation, and 3D TVs and gaming etc. They also are licensing their technology to Elpida in an important JV to build NAND. The embedded markets are characterized by steady demand and ASPs, high customer retention, little interest in advanced node technologies, and 5 to 10yr product lives.

Background:

Spansion was originally formed by AMD and Fujitsu. In the years leading up to its restructuring, it was a company run by engineers for engineers. Tremendous amounts of money spent on R&D, non-core business lines, and capital spending while primarily competing with Samsung and Numonyx to provide NOR flash for the hyper competitive handheld market. Low margins (if positive at all), tremendous cyclicality, and huge capital intensity were constants. Unlike many modern restructurings, Spansion actually went through both a financial restructuring and a true business restructuring. Some key aspects of the business restructuring included the following:

• Exiting the bulk of the wireless business to focus on embedded markets
• Reducing headcount ~60% and focusing R&D on core business & product extensions
• Abandoning SP1 their new fab built in Japan, and creating a hybrid model whereby Spansion utilizes there fab in Austin, TX for ~65% of their product. This keeps it at running at near 100% capacity with an “asset-lite” model for the rest of their wafers. They utilize the same model with assembly and test facilities (2 owned but utilize 3rd parties as well).

As a consequence of the restructuring, Spansion cut sales approximately in half, but took gross margins from 4% to mid 30s and they are on their way to north of 40%. This was accomplished by focusing on the embedded market. By focusing on the embedded market, they are selling into customers whose product life is 5-10 years. The orders are stable and predictable and once they are designed in, it tends to be very sticky. They have excellent visibility as they do not produce much of any spec product, and this is corroborated empirically by 8 consecutive quarters that have met or exceeded guidance. Due to the longer term nature of the products made by the embedded market, the business has low capital intensity. In fact, the company suggested that these attributes were always attributes of the embedded business, but it was invisible to outsiders based on poor segment level disclosure and the cash generated by the embedded business was swamped by the cash furnace that was the wireless division.

Capital Structure as of 3/31/11:

Cap leases $1.7

Secured TL $251

Unsecured Bond $200

Cash and securities $308

Investment Thesis:

Spansion spent over $1B on R&D in the 3 years leading up to the bankruptcy. They already have process technology and IP for the next 2 smaller node sizes. This gives them a roadmap to produce more advanced flash products (transitioning from 110 to 90 to 65 to 45nm) for the better part of this decade. Spansion can now in effect, monetize much of the expenses incurred by previous investors. This is driving all sorts of new products specifically targeting existing and new markets. They brought 4 to market in 4Q10, with 17 expected this year. All at 65nm (at the forefront of NOR flash) and designed with the embedded market in mind. This is driving significant design wins that is expected to boost their embedded market share from 36% up into the 40%+ area (Numonyx is #2 with ~20%, and at the higher densities this duopoly is even more significant). These new products have driven numerous design wins which is one reason Spansion has quantified $15-30mm in top line as the estimate for 2011 from the Japanese tsunami and still haven’t lowered their guidance. Incremental demand in 2012 for the rebuilding efforts should further bolster pricing and volume. Also, Spansion now believes they will sell $75-100mm in NAND flash from their JV with Elpida in 2012. They see this as a ~$500-600mm mkt which think they will get ~approx. 1/3 of the share. This does not include any possible licensing royalties from NAND sales by Elpida. Spansion also recently settled all of their outstanding litigation with Samsung, which is providing for $150mm in revenues over 6 years. Also as part of the settlement, they stipulated an outstanding claim in the bankruptcy estate. Spansion agreed to buy back that claim and retire the shares.

Their products are known for their reliability, durability and ruggedness. This is one reason Spansion does so well in the auto industry, where products must meet not only strict specifications, but also be qualified and supplied by reliable suppliers. The content per vehicle is going up. The designs are done. All new safety and security systems, infotainment, and in fact every time you see an electronic screen in the cabin, it generally requires NOR. It’s necessary because it has instant boot up time and it doesn’t drop bits like other memory (NAND). These same traits are why NOR is going into industrial automation, advanced Set top Boxes, communications equipment, smart meters etc. etc. In fact, the same “drivers” of business that people like in companies like FSL, ADI, LLTC, TXN etc. all generally benefit Spansion.

In addition to the core business, which is growing with expanding margins, there are new opportunities to monetize Spansion’s 1696 US patents (873 foreign, as well as 502 and 840 applications are pending both in the US and abroad respectively). The royalties from Samsung will bolster the top line and cash flow by $25mm and ~$20mm per year (NOLs shield in US, some leakage in Korean sub) respectively. I believe we will see Spansion attempt to go after some or all of the following: MU, Toshiba, Hynix using the Samsung settlement as a guide to try to extract further value going forward.

Another example of Spansion being able to “monetize” its IP is with a JV with ELPIDA. ELPIDA is a significant DRAM manufacturer and had interest in entering the NAND market. ELPIDA and Spansion have formed a JV with a licensing agreement that provides royalty payments and product near cost to Spansion for its non-exclusive use of its Mirror-bit technology which is slated to ship product before the end of 2011. This NAND is not intended to compete against Samsung, Toshiba or Micron in the hyper competitive NAND found in handhelds, computers or tablets. This is “ruggedized” 1-2GB 43nm SLC NAND that is targeting niches in industrial applications where increased performance and reliability are needed. It appears to be a complimentary product and doesn’t appear to be likely to cannibalize NOR given early indications from design engineers. In discussions with Micron, they corroborate CODE’s contention that there is real demand for this new aspect of the NAND market. The $75-100mm target will be very backend loaded in 2012, but should ramp from there assuming the product timeline doesn’t slip. CODE should be able to keep low to mid 30’s on the GM on this (lower, b/c they will have to pay some small margin to Elpida above cost. Elpida is working on 3x and 2x nm NAND to compete with the big guys. The TAM for NAND is growing rapidly as is estimated at ~$25B. If Elpida can carve out even a piece of this mkt, and with a mid single digit royalty, this could provide a solid tailwind just on royalties alone. Spansion has no capital commitments to the JV. Spansion holders have optionality on this new product which I do not believe is discounted today.

All microcontrollers use NOR. Historically microcontroller manufacturers have utilized in-house NOR exclusively for consumption embedded into their microcontrollers. This NOR is bulky, not technology advanced, and there is likely to be opportunities to license Spansion’s technology to microcontroller companies looking for superior performance and smaller form factors. It’s unclear and probably unlikely that there is anything imminent on this front, but this has been confirmed to me by large microcontroller companies as being a truly sensible partnership opportunity. Spansion has actually indicated that they are now starting to field incoming interest from other companies on this front. This optionality is not widely understood and certainly not discounted.

The core thesis is that you have a hugely cash generative business, that is characterized by stable predictable orders, benefitting from a global trend towards increased electrical automation and increased content in all manner of industrial applications. EBITDA growth is continuing to grow steadily yoy each quarter in the core business, and now with the licensing revenues, CODE should have nearly double digit rev growth for the next two years and over 20% growth in EBITDA this calendar year. Incrementally you are long optionality based on litigation strategies and licensing opportunities on the IP portfolio.

These are based on conservative estimates and do include an estimate for what the NOLs are worth. There is good disclosure and given the bulk of the PV of the NOLs are usable within 3 years I get a PV of only the Federal NOLs of $165mm.

Multiples are primarily a reflection of three things: FCF conversion rate, volatility of operating results, and growth. Spansion has excellent FCF conversion based on its low capital intensity and its model. This is not a DRAM or NAND company! The volatility of cash flows has been very low over the last 8 quarters. No big surprises and no misses. It’s an annuity like business. Public comments from MU corroborate this when they discuss the nature of the embedded markets at Numonyx, and Spansion’s flexible model reduces operating leverage cyclicality. Spansion is growing, despite multiples lower then those of the yellow pages and newspapers. iSuppli suggests 3% CAGR for the embedded NOR market through 2014, which Spansion suggests does not pick up the whole market. Spansion is growing embedded NOR revenues (81% of revs) north of 10%, with the wireless business coming down (19% of revs) 10-15%. This has the core business up 6-7% on the topline prior to the Samung royalties. Add in the new royalty stream, and you have sales growth of 8.8% this year and 8.7% next year.

MU is a memory company and has a division that is ostensibly Spansion’s best comp. But in aggregate, nothing about MU’s business looks similar from a financial perspective. Its hugely capital intensive, exhibits tremendous cyclicality, is hyper competitive with companies with more resources, has poor if not negative ROIC, and short product life cycles. It’s almost the mirror opposite of Spansion. Spansion’s business attributes much more resemble the analog companies. ADI, LLTC, MCHP, ATML, ONNN trade with EV/EBITDA multiples ranging from 8-11.5x and FCF yields ~4.5-7.5%. Spansion will probably never fully escape its memory stigma, and is not well followed as it operates in a weird little niche that regular tech analysts don’t understand or spend any time on. So it will realistically probably never close the entire gap of relative value, but as the cash continues to pile up, which it has been doing for over 2 years, it will become harder to ignore. At $30, Spansion would be at 5.2x ’11 EBITDA and trading at an 11.6% ’11 FCF yield and we have yet to add value from royalties from Elpida sales or other incremental value from future licensing opportunities. This seems to me to be a rather conservative PT still at a significant discount to the analogs, if they continue to grow mkt share or gross margins, there is upside to this number.

Catalysts:

• Stock sold off hard after Japanese earthquake, and despite solid guidance quantifying the effects, skepticism in the market will fade over next couple of quarters - even more so 2012 demand to rebuild should be a tailwind
• Removal of the overhang from the resolution of the claims pool and final distribution of reserve pool shares
• Significant earnings growth as gross margins climb up over 40% bolstered by the transition to 65nm products and increased overall sales. This should help sentiment as this arbitrary level is used as a benchmark by many tech investors and might help change perception and thus the multiple.
• I actually thought the stock would get a much better reaction to the positive Samsung outcome. All of the street estimates are too low for ’11 and ’12 as they have not updated numbers to incorporate the Samsung royalties or the NAND sales later next year.
• The run off of fresh start accounting will drive GAAP gross margins and earnings higher as increased D&A resulting from inventory step up, cycle off and higher cost inventory no longer boosts COGS - street coverage have been focused on these and i think will be forced to revise targets higher

Risks:

• If SPI or serial peripheral interface NOR (primarily made by Macronix and Windbond) can somehow come up market to more directly compete with parallel interface NOR at higher densities which is where Spansion and Numonyx really dominate, that could change the stable ASP that characterizes the embedded NOR market. While possible, nothing currently suggests this is likely.
• If Spansion does something ill advised with its cash as it continues to accumulate. This is a bigger risk to me, but hopeful that the 2 board members from Silverlake can act somewhat to mitigate this. Spansion has done accretive buybacks of claims in the bankruptcy, and this most recent retirement from Samsung is a continuing this.
• MRAM, FRAM, phase change or some other memory technology comes along that displaces NAND and/or NOR. This has been a discussed risk for 20 years with no demonstrated increased likelihood of displacing current flash memory technologies. Adoption of NAND with error correction in industrial applications is a risk as well. However there is no sign that industrial chip set designers view that as a superior solution as they continue to use NOR.

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Post Re-Org Equities: Russell 1000/2000 Index Changes

In 2006, Baupost's founder and president Seth Klarman gave a talk at Columbia Business School. In his talk, Klarman noted that Baupost has analysts that focus on very specific events: spin-offs, post re-org equities, distressed debt, etc. One set of analysts that I had never heard of a fund employing: analysts that focused on the addition and deletion of stocks in certain indexes like the S&P 500. As one would expect, when a company gets added to the index, passive funds (mutual or ETF) must buy the quantity of stock needed to match the company's weight in the index. Conversely, a stock that is removed from an index will see "forced selling" of their equity as passive strategies sought to match the index components.

In fact, this is one of the reasons that Seth Klarman, arguable the best hedge fund manager out there and one of three people Buffett has said he would allow to manage his money (source: Bruce Greenwald), has said why indexing is such a dangerous strategy (from Margin of Safety):

"Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they transact. Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index...

A related problem exists when substantial funds are committed to or withdrawn from index funds specializing in small-capitalization stocks. (There are now a number of such funds.) Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalization-stock indexers receive more funds, their buying will push prices higher; when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to underperform their indexes. "

On June 10th, Russell announced their annual reconstitution preliminary additions and deletions. You can view the data here: Russell Reconstitution. On Friday, June 24th the reconstitution will go into effect.

We know over the past year that a number of post re-org equities have been listed on the exchanges. With that said, we would expect to see a number of post re-org equities in the addition column on the Russell indexes and that's actually what we see. Here are the list of post-re org equities, and the associated Russell (either 1000 or 2000) indices they are being added to:

• BKU - BankUnited (Russell 1000)
• GM - General Motors (Russell 1000)
• CHMT - Chemtura (Russell 2000)
• CHTR - Charter Communications (Russell 1000)
• FRP - Fairpoint (Russell 2000)
• LYB - Lyondell (Russell 1000)
• SEMG - SemGroup (Russell 2000)
• SIX - Six Flags (Russell 2000)
• VC - Visteon (Russell 1000)

What compounds the problem on some of the smaller stocks above, is that the free float may be a very small percentage of total shares outstanding. As some bankruptcy plan support agreements require fulcrum security holders to hold onto their stock for a certain number of days, the true liquidity of a stock may be quite small. Furthermore, there may be no equity holders, that participated in the bankruptcy, ready to sell the stock because a lack of value realization.

Let's take Six Flags as an example. Bloomberg lists 27.575M shares outstanding. The new proposed weighted in the various indices (Russell 2000, Russell 3000, and Russell 2500) will require a purchase of approximately $111M worth of shares, or approximately 1,500,000 shares as of today's close. Since the end of the 1st quarter, the average volume of the stock is approximately 160,000 shares. This is 9 days worth of volume just on the passive side. Rehan Jaffer's H Partners, a well know event-driven hedge fund, owns 6.6M shares or ~25% of the shares outstanding. If he (and BHR Capital, the #2 holder) decides to not sell into the passive investor's hands, there could be a squeeze for the shares pushing the price artificially higher.

I would expect a small bump in the stocks listed above in the last week of the month as Russell passive funds look to match the new index constituent lists. Likewise, while not post-reorg equities, a number of the very small companies that did not make the market cap minimum this year on the Russell 2000 will be deleted from the index. Somtimes already illiquid, investors may see some interesting value opportunities in the names. These include PCTI, TPGI, AMNB, HOFT, and CUTR. Happy hunting.

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Distressed / Event Driven Funds Take Aim at Smurfit-Stone

A few months ago we highlighted some of the hedge fund ownership of Smurfit-Stone's post re org equity as determined from the HD function on Bloomberg. With that, I am sure all my readers know that Smurfit-Stone has agreed to be acquired by Rock-Tenn. Yesterday, three prominent distressed / event-driven funds sent a letter to SSCC's Board of Directors calling the acquisition price essentially a sham.

In the letter, Third Point, Royal Capital Management, and Monarch Alternative, collectively holding approximately 9% of the company's outstanding shares (60% acquired via the re-org process), express disappointment "at the merger terms [the Board] approved, and to announce [their] intention to vote against the Merger as it stands today."

Their argument is very well laid out and I have included the entire letter below. For full disclosure, I am long SSCC calls as I believe the take out price is far too low. I particularly like the point about the incentives of the acting CEO to sell the business as soon as possible - a point I try to reiterate over and over on this site. Furthermore, the fantastic people over at Footnoted had SSCC as one of their Top 10 acquisition candidates for 2011. They write:

"Just last week, the company filed an 8-K with updated information about the Dec. 31, 2010 resignation of Steven J. Klinger from his roles as President, Chief Operating Officer, and director. The resignation was surprising at first, given the fact that the company had just inked an amended employment agreement with Klinger last summer following its emergence from bankruptcy. But when we dug deeper, we learned that Klinger and the company had previously agreed that within 30 days after Smurfit-Stone got notice that its CEO-at-the-time intended to leave, the company would consider promoting Klinger to the roles of President, CEO, and (potentially) Chairman of the Board. We know that Moore is expected to retire sometime in the next few months, and yet the board did not tap Klinger for the CEO post.

Although Klinger officially resigned, he will be sticking around a bit longer because of an agreement that he and Smurfit-Stone made on New Year's Eve. Per that arrangement, Klinger agreed to work as a consultant from New Year's Day through March 31, 2011 in exchange for the tidy sum of $150,000 per month. He's to perform whatever consulting services the CEO and the Board "reasonably request" him to render; the document doesn't offer any further details. But the agreement appears to be about more than just the money. It also states that when the Consultancy Agreement expires on March 31, 2011, Klinger's unvested options and RSUs will remain outstanding for six more months. If a change in control occurs during that window of time, Klinger's awards will immediately vest.

Given the short-term of the consulting agreement and the specific conditions which benefit Klinger if a change in control occurs by the end of September, we think it's possible that negotiations for a sale are occurring."

If that's not GOLD, I do not know what is...

Enjoy the letter!

SSCC Activist Letter

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13Fs and Post Reorg Equities

One of the my favorite times each quarter is the 45th day after quarter end when hedge funds report their holdings in stocks. My good friend Jay at Market Folly is far and away the best coverage of 13Fs out there and I strongly you suggest you frequently check his site for analysis of some of the best hedge funds in the world.

As a distressed/event-driven investor, I allocate a substantial amount of time to post reorg equities. Many distressed debt funds have a mandate to purchase companies emerging from bankruptcy or who have recently emerged from bankruptcy. Many funds stretch the "recently" to five, six, or even seven years so you will see many distressed funds in names that many people forget even went through the bankruptcy process.

With that said, I also like to look at companies which have recently emerged from Chapter 11 and have a substantial float to get a sense of what event driven and distressed debt funds are doing in these post reorg securities. Let's take a look at a company which recently emerged: Smurfit Stone (SSCC respectively).

Before we begin though, one caveat. Many distressed debt funds will play a reorg prior to a emergence, and then wait until the company is listed and possibly picked up by an index to sell the security into the index buying strength. As with all 13Fs, these filings are just a way to find more ideas and get a sense of what funds are doing out there in post reorg land.

On June 30th, SSCC announced its emergence from bankruptcy. Let's take a peak at their holders list (I've decided to include only the top 30 holders here):

As you can see, this list of 30 funds is a pretty diverse group. Just looking at the top 15 holders (top image), here are the funds I see:

• Royal Capital Management: A well regarded long/short hedge fund that also has played in Lear.
• Apollo Management: Self-explanatory - one of the best.
• Wayzata Investment Partners: All over the distressed scene playing in recent bankruptcy emergences like Neff, Rath Gibson, and Merisant
• Columbus Hill Capital: Started by a former Appaloosa partner (they are also located in Short Hills, NJ), their 13F has names like Dana, MGIC, PMI, Lear as well as some well known large caps like BAC and IP.
• Elm Ridge: Started by Ron Gutfleish who spent time at Omega and GSAM, Barron's wrote in April 2004: "Gutfleish and his posse run their hedge-fund operation from an ultramodern New York office building on Third Avenue. They pride themselves on their ability to stir the pot of controversy. In the almost four years it has been in operation, Elm Ridge has won a reputation for being able to make money in all sorts of markets by aggressive analysis and bare-knuckle trading."
• Brigade Capital: One of the newer members of the distressed pack but also highly highly regarded. Very smart group of portfolio managers and analysts there that play up and down the capital structure and strategies.
• JGD Management i.e. York Capital: Blue chip and as best as they come.
• P Schoenfeld Asset Management: Check their website. Great stuff.
• Litespeed Management: Well regarded event-driven fun run by Jamie Zimmerman, playing in merger arb, distressed debt, and special situations.

Next quarter, after the 12/31/2010 13F filings are in we will re-visit this post re-reorg equity to see who stayed in versus who flipped the security after it emerged from bankruptcy.

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Investing in Post-Reorg Equities

We would like to welcome a new writer to Distressed Debt Investing - Julia Bykhovskaia, CFA will be joining us as we start discussing more post reorg equities on the site. Enjoy!

INVESTING IN POST-REORG EQUITIES

Post-reorg equities can often present compelling risk-reward opportunities for a value investor. However, even though stocks of the companies that recently emerged from Chapter 11 provide fertile ground for bargain hunting, blindly investing in post-reorg equities (as in any other securities) certainly does not guarantee investment success.

There were a few studies performed that focused on the price performance of the post-reorganization stocks. For example, in their 2004 study “A Chapter after Chapter 11”, Lee and Cunney of JP Morgan looked at 117 companies that came out of Chapter 11 between 1988 and 2003. They found that relative performance (to the S&P 500) of these companies’ stocks averaged 85% in the first year after emergence. However, the same study showed that volatility of these stocks had been very high, with only 50% of the equities outperforming during the period.

Thus, while it is clear that opportunity for outsized returns exists, as with any kind of investing, investors are well-advised to conduct a thorough due-diligence and to be selective in their stock picking. Not all post-reorg equities are created equal; some companies emerge from Chapter 11 without accomplishing any substantial operational turnaround or debt restructuring – only to file for Chapter 22 not too long after original emergence (Bally Total Fitness, Foamex, Movie Gallery, Trump Entertainment are just some such examples).

Yet, there are a number of reasons for post-reorg equities to be inefficiently priced and such market inefficiency creates opportunities for investors hunting for bargains. Let’s look at some of the reasons why such mispricing can exist and why these stocks can have a potential for generating attractive returns.

Composition of the Equity Holders

The original holders of most post-reorg equities are former creditors (with some exceptions where former stockholders continue to own stock in the company post-bankruptcy; e.g. General Growth, Pilgrim’s Pride) – usually the holders of the company’s bank debt, bonds and trade claims and executory contract-rejection claims. Some of these newly minted equityholders are not in the business of managing money; they entered a distressed situation unintentionally and may not even be allowed to hold equities under their mandates. Banks and insurance companies, for instance, prefer to receive cash or cash-paying debt as a distribution in bankruptcy rather than common stock for regulatory and economic reasons. Landlords who received shares in the new company in exchange for their lease-rejection claims or vendors of the company who received their shares as a distribution for their trade claims may also be part of this category. High Yield funds may not be allowed to hold equities by their charters. All these holders can become “motivated sellers” and may be forced to sell the shares in the newly emerged company for noneconomic reasons and without giving consideration to valuation or potential returns – and thus creating mispricing.

Small Market Capitalization and Illiquidity

Many post-reorg equities are small cap names. Therefore, large institutional investors, which are often looking to place hundreds million dollar bets on each company, will not have these companies on their investment radar. Reorganized companies are simply too small for them to invest in. Similarly, post-reorg equities are often illiquid. Not only do they tend to be small cap names, but trading float can be small as well. Distressed control-type investors can be long-term holders of these equities and thus might be unwilling to trade their positions. Since liquidity and size are important considerations for many portfolio managers, these relatively illiquid small cap stocks are quite often simply ignored by many professional investors.

Lack of coverage by Wall Street equity analysts

As we mentioned before, the equities of formerly bankrupt companies often have small market capitalization and tend to be illiquid, at least at the beginning of trading. Since Wall Street generates more commissions from trading larger cap, very liquid names, Street analysts are not incentivized to spend time and resources to cover post-reorg equities given that the potential for generating substantial commissions or investment banking business is low. This is why post-reorg equities are often referred to as “orphan equities” – nobody cares to look at them. There are a handful of boutique sell-side firms which provide research on some post-reorg names; however their coverage is limited.

Information Access

Gathering information on post-reorg equities might be challenging as well. During the bankruptcy process, companies generally don’t host conference calls, rarely make public appearances at the conferences and sometimes do not file 10Ks and 10Qs with the SEC. To understand the company’s post-emergence capital structure and newly issued securities, it is imperative for an analyst to read the Disclosure Statement filed with the bankruptcy court which includes financial projections, the company’s new capital structure as well as liquidation and valuation analyses. Analysts can also look at the company’s Monthly Operating Reports, also filed with the court, for more detailed monthly financial data. All these documents are available to the public from the electronic court filing system PACER (http://www.pacer.gov/) for a small fee. However, even though the information is accessible, most non-distressed investors tend to be unfamiliar with PACER and bankruptcy documents, thus often neglecting post-reorg equities altogether.

Bankruptcy Stigma

One of the indirect bankruptcy costs is a stigma directed towards the companies which have gone through Chapter 11. Oftentimes there is a perception that a firm which is or was in bankruptcy has irreparable damage to its brand name and will have trouble retaining old customers and acquiring new ones, getting good payment terms from its vendors, and keeping its key personnel. While this view might be partially true in some situations, it is not rare to see a company do quite well after Chapter 11. It is especially true if the main reason for bankruptcy was overleverage and not underlying business problems. Moreover, bankruptcy process can often become a positive catalyst for a company – the company can use Chapter 11 to reject leases, renegotiate more favorable contracts with suppliers, rationalize workforce, sell underperforming assets, close unprofitable stores, install new management as well as substantially reduce debt load and in some instances get new capital injection. Many companies emerging from bankruptcy also have substantial NOLs which can be used to offset taxes due in the future. All these actions can allow the company to emerge as a healthier, more profitable firm with improved business model and reduced risk profile.

Conservative Projections in the Plan of Reorganization

Since management is often getting stock options (as well as warrants and some percentage of the new equity) in the reorganized company, they can be enticed to provide conservative projections in the Plan of Reorganization so they could price their stock options at a lower price and also outperform their own projections in the future to equity analysts applause. Another reason for preference of a low valuation by management is that it allows the firm to emerge with less debt on its balance sheet. While not always the case, the practice of providing overly conservative financial projections is not uncommon and analysts should be on a look out for such situations.

To conclude, post-reorg equities are often ignored and misunderstood by investors. Every year, 20-30 firms usually emerge from Chapter 11 as publicly traded companies (to name just a few examples, such companies as Tronox, Chemtura, Lyondell Chemical, W R Grace are expected to come out of bankruptcy in the next 12 months). Because many investors are unwilling or unable to invest in these stocks, equities of formerly bankrupt companies can provide attractive value-investment opportunities. Outsized returns may be achieved by wisely investing in select post-reorg equities and we hope that this blog will provide our readers with some guidance and advice on post-bankruptcy investing and help better understand and value these situations.

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